A real estate investment trust (REIT) is a company that lets investors pool money to invest in real estate. REITs have special tax status that requires them to pay out at least 90% of income as dividends. This can be lucrative for investors – but comes with many of the usual caveats associated with investing in real estate.
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REITs must follow specific rules. For example, there must be at least 100 shareholders and no 5 shareholders can own more than 50% of the shares. At least 75% of assets must be invested in real estate, cash or Treasurys. Also, 75% of gross income must be derived from real estate.
Types Of REITs
There are two main types of REITs, equity and mortgage. Most REITs are equity and those are the ones most investors are familiar with. Equity REITs own and manage properties. The way equity REITs make money is simple. They buy properties and lease them to tenants. Most of the income in equity REITs comes from rent and much of that rent is passed along to shareholders as dividends.
Mortgage REITs invest in mortgage-backed securities such as those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. They also invest in non-agency or commercial mortgages. They make money by borrowing money at low (short-term) rates and buying mortgages that pay higher (long-term) rates. The difference between the two types of interest is the profit, again mostly paid to shareholders.
Between the two types of REITs, mortgage REITs can be extremely volatile due to unexpected changes in the spread between short-term and long-term interest rates. Equity REITs, on the other hand, tend to be less volatile with some returning steady income – almost like bonds – over many years.
The differences in volatility probably explain the fact that equity REITs are much more popular than mortgage REITs. In fact, mortgage REITs make up only about 10% of the REIT market. There is a third, very rare, type of REIT known as a hybrid REIT. As you may have guessed, a hybrid REIT invests in both mortgages and property. Hybrids take a more balances approach that allows them to profit from both rising and falling interest rate environments, something that can provide to be a challenge for mortgage-only and equity-only REITs.
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The Role Of REITs
Real estate investment trusts are worth considering for investors seeking diversification, higher total returns and lower overall risk. REITs can help generate dividend income and capital appreciation as a counterbalance to more traditional choices like stocks, bonds and cash. One additional benefit of investing in REITs is the fact that many have dividend reinvestment plans (DRIPS). Along with high-yield bond funds and well-chosen dividend paying stocks, REITs can help provide a reasonably stable income stream for many years.